Evaluation of Financial Systems and their Impact on the Poor

This project, by CFSP’s faculty director Robert M. Townsend, combines multiple components and focuses on benchmarks to gauge how well financial systems, in all aspects, and the larger economy are functioning to alleviate poverty. It also examines what improvements in existing financial systems might be most effective.

The primary goal of these research activities is to provide an integrated framework into which the diverse research of CFSP’s researchers can be fit together to ensure a comprehensive approach to financial systems and poverty. This includes linking several key subfields: finance, industrial organization, macroeconomics, international macroeconomics, trade, labor, public finance, econometrics, economic history, and mechanism design/contract theory.

Townsend’s project features four major components:

1. Benchmarks for Measuring Efficiency of the Financial System
Research and the literature has been developing operational benchmark tests that can be used to judge how well the poor are doing in conjunction with the larger community relative to standards suggested by perfect markets or an equivalent set of institutions. The policy implication is clear: if not perfect, then there is an indicator that one can begin to think about interventions. If perfect, then interventions at most would redistribute income at the village level and household specific interventions might be ineffective. This research involves the development of more sophisticated and more robust tests, primarily in Thailand where Townsend has been collecting panel data for over ten years. Some of the questions he seeks to answer include:

Why do households opt to hold large amounts of cash rather than invest in savings?

How does labor supply move in response to wage rates and other shocks allowing tests of the overall efficiency of intermediation, even though income is endogenous?

What role do diverse risk preferences play in the allocation of aggregate risk, so that individual vulnerability can be distinguished from the proportion of macro shocks that are borne?

What implications do efficient markets have for rates of return to household assets and how can returns be adjusted to properly take into account that aggregate shocks cause movement in returns?

2. Networks and Intermediation in Developing Countries
Savings is important as it is one of the two crucial halves of a well-functioning financial system. Both savings and credit are linked through intermediation. Yet, there are few deep models on why banks exist per se (as opposed to intermediation), and, more generally, little understanding of why intermediation takes the form that it does. It is possible that what happens in many countries is the outcome of regulatory restrictions instead. The goal of this project is to better understand what indigenous financial systems look like, such as local risk sharing networks, and to examine their interface with more formal existing financial sector providers. Some of the questions that Townsend and his colleagues are pursuing include:

Why does intermediation take the form it does? How does it relate to the presence of banks and what does that mean for the poor?

What do indigenous financial systems look like compared to what the formal existing financial sector provides and how might these interact with consequences for the poor?

What effect do finance and liquidity have on the poor in developing countries?

Are improvements in financial system welfare improving for everyone or rather do innovations that circumvent collateral constraints shift income in favor of the poor at the expense of the relatively better off?

3. The Industrial Organization of Financial Sector Providers
Financial access is determined in part by how closely a bank branch is located to the poor. Using data from Thailand’s governmental Bank for Agriculture and Agricultural Cooperatives (BAAC), and GIS system and spatial statistics, this project will examine patterns in branch bank locations in Thailand. A primary goal of the project is to understand the interaction of government and private sector financial providers and their impact in reaching the poor. To bring data and models closer together, recent advances in methods in the industrial organization literature will also be examined. Some of the questions that are being explored include:

What determines the natural expansion of financial infrastructure?

What role do government banks play relative to commercial banks? Is poverty reduction related to their strategic interaction?

What patterns of expansion typify an OECD country such as Spain?

What are the industrial organization patterns of various financial sector providers in Mexico and other countries, in both sudden stops and capital inflow periods?

4. Applied General Equilibrium Macro Models with Realistic Micro Underpinnings
This project builds on earlier published work by Townsend and his colleagues on applied structural general equilibrium models that give a key role to the financial system in helping to determine the evolution of poverty, inequality and growth. We need to understand how financial systems have evolved in the past and how they are likely to in the future in order to predict consequences for the welfare and well-being of poor households. Collaboration with fellow researchers will address the impact of government macro policy distortions, and financial sector and macro reforms impact. Additionally, a comprehensive framework for the analysis of financial systems will be presented in a forthcoming book, building off of the Thailand model. The long-term goal is to then incorporate these projects into computational algorithms. Knowing if and where imperfections exist, policy interventions can be put in context. Some of the questions Townsend and his colleagues intend to answer include:

What is the role of an expanding financial system in reducing poverty, both directly through services and indirectly through impact on wages and other prices?

What damage is associated with restrictive government policy and is this particularly damaging to the poor?

How well do these models do in prediction of the expansion of the financial system at the village level (i.e., fine tuned geographic prediction)?

Can more realistic models be built that take into account internal trade, combining real financial sectors with limited intermediation?

Research Questions:

How does participation in the formal and informal banking system affect the poor's ability to smooth consumption and investment compared to the non-poor?

Why do households opt to hold large amounts of cash rather than invest in savings?

How does labor supply move in response to wage rates and other shocks allowing tests of the overall efficiency of intermediation, even though income is endogenous?

How does labor supply move in response to wage rates and other shocks allowing tests of the overall efficiency of intermediation, even though income is endogenous?

What role do diverse risk preferences play in the allocation of aggregate risk, so that individual vulnerability can be distinguished from the proportion of macro shocks that are borne?

What implications do efficient markets have for rates of return to household assets and how can returns be adjusted to properly take into account that aggregate shocks cause movement in returns.?

Does idiosyncratic risk remain in a risk premium so that vulnerability should remain a policy concern?

How do the poor’s choice of technology and inputs affect their response to rainfall and other shocks, and can they adjust as well as others to climate change?

Why does intermediation take the form it does? How does it relate to the presence of banks and what does that mean for the poor?

What do indigenous financial systems look like compared to what the formal existing financial sector provides and how might these interact with consequences for the poor?

What effect do finance and liquidity have on the poor in developing countries?

Are improvements in financial system welfare improving for everyone or rather do innovations that circumvent collateral constraints shift income in favor of the poor at the expense of the relatively better off?

What determines the natural expansion of financial infrastructure?

What role do government banks play relative to commercial banks?

Is poverty reduction related to their strategic interaction?

What patterns of expansion typify an OECD country such as Spain?

What are the industrial organization patterns of various financial sector providers in Mexico and other countries, in both sudden stops and capital inflow periods?

What is the role of an expanding financial system in reducing poverty, both directly through services and indirectly through impact on wages and other prices?

What damage is associated with restrictive government policy and is this particularly damaging to the poor?

What are more realistic micro underpinnings for these models and how can they be estimated and incorporated into computation algorithms?

How well do these models do in prediction of the expansion of the financial system at the village level (i.e. fine tuned geographic prediction)?

Can more realistic models be built that take into account internal trade, combining real financial sectors with limited intermediation?